Fortescue successfully launches a new 9.75% secured bond issue

Last Thursday, Fortescue announced the successful completion of a new US high yield bond offer, which will be used to pay out its near term bonds.

Key points:

• The transaction was initially announced as a USD1.5bn senior secured bond, and following strong appetite the deal was upsized to USD2.3bn
• The new bond has a seven year final maturity and is callable after three years, and is paying a high coupon of 9.75%
• Fortescue will use the net proceeds of the bond to:

1. Redeem the outstanding 2017 and 2018 senior unsecured bonds.
2. Swap certain 2019 Notes for new senior secured bonds.
3. Repay, redeem, repurchase or otherwise retire outstanding indebtedness maturing in 2019.

• The company has outlined that approximately USD450m of 2019 senior unsecured bonds will be repurchased, repaid or swapped into the new secured bonds
• On the reported figures, the company will have an additional USD350m in cash available after debt is repaid, on top of the USD1.8bn cash balance reported at 31 March, bringing its total cash balance to around USD2.1bn
• The terms and conditions of the bond are substantially consistent with the company’s existing debt. All debt facilities have no financial maintenance covenants
• Further, there is no news of an extension of the existing secured term loan facility, which means the company will have USD6bn of debt maturing in 2019
• The offer is expected to settle on 27 April 2015

It has been reported in the media that two of Fortescue’s largest existing bondholders, Franklin Resources Inc and the Capital Group, were the lead proponents of the new bond issue. It is suggested that these two investors, rather than the company or its advisers, were the architects of the new bond issue. Between them, the Franklin Resources and the Capital Group agreed to buy most of a USD1.1bn parcel of the new bonds via ‘reverse enquiry’ to Fortescue. We suggest this is a useful read to understand the dynamics of the US dollar bond market, particularly transactions where large US fund managers are involved. Read the article here.

We note that Fortescue is paying a much higher coupon on the new secured bonds compared to previous issues. Its average cost of borrowing over 1H15 was 5.27%, and the company is now paying almost double that for a secured bond issue at 9.75%. The company had repeatedly mentioned it was in no hurry to repay its debt, however the recent falls in the iron ore price and the fall of Atlas Iron would have placed pressure on the business to act quickly. This new bond issue is a case of one step backward (raising very expensive secured debt) to take two steps forward (manage its debt maturity profile and calm the market).

The callability of the new bond after only three years suggests the company will be very keen to replace this expensive secured debt early should iron ore prices recover over the next three years.

Following the new issue, we have seen strong rallying across the 2017, 2018 and 2019 unsecured bonds, and a smaller rise in the 2022 bonds. Going forward, we consider the new bond raises both positives and negatives for the company and existing unsecured bondholders.

Key positives:

• Extending the debt maturity profile is positive news for the company, and with no material debt maturing until 2019 the company has bought itself additional breathing space given the short term volatility in iron ore prices. The following chart shows Fortescue’s pro forma debt maturity profile after the transaction is completed. This includes the full redemption of 2017, 2018 and partial redemption of the 2019 senior unsecured bonds.

Source: Fortescue Metals Group

• The fact that the deal was upsized by USD800m indicates that there is continued strong interest in the Fortescue name and supports the thesis that there will be continued funding support for the business to refinance later dated maturities. Access to funding in a stressed environment is a good indicator that the market believes in the viability of the company, although we recognise the company has had to pay a substantially higher interest rate versus other existing debt to get the deal away
• For 2019 bondholders, the reduction in debt outstanding from USD1.5bn to about USD1.05bn (estimate) is likely to support improved pricing given the rebalance in bond supply and demand. In addition, the 2019 bonds will become the equal earliest maturing debt along with the USD4.9 senior secured term loan, which we understand hasn’t been extended. In the face of USD6bn of debt needing to be repaid in one single year, we expect the company will try to stagger the repayment or refinance of this debt, and an early call on the 2019 unsecured bonds remains a possibility

Key negatives:

• The new secured bond issue weakens the position of the unsecured bonds in the capital structure and significantly reduces the expectation of recovery for the unsecured bonds in the event of a default. Following the secured bond issue, Moody’s downgraded the credit rating on Fortescue’s unsecured bonds by one notch to B1 reflecting their weaker position in the capital structure. This follows both rating agencies already downgrading Fortescue’s credit rating in the past week by one notch to Ba2/BB after their recent downward revisions to iron ore price forecasts.
• We expect the higher level of secured debt in the structure will also increase volatility in pricing of the remaining 2019 and 2022 senior unsecured bonds. As iron ore prices fall, the probability of a default on Fortescue increases, and the yield differential between the secured and unsecured bonds will increase due to the negligible recovery expected on the unsecured bonds in the event of a default. Having said this, the opposite is also true if iron ore prices continue to rally as they have over the last week
• Fortescue had to pay a substantial premium above existing debt issues to get this deal away. Fortescue’s cost of finance and gearing have marginally increased following this transaction based on the reported details, which will only slightly increase production all-in costs per tonne
• As we approach 2019, there will be increased pressure on the company to repay some of the USD6bn debt early. Note that, while the prospect of USD6bn of debt maturing in one year presents risk for the company, it also increases the chances of an early call on the 2019 unsecured bonds which would be a positive outcome for 2019 bondholders if it were to occur

Summary
As a result of this new bond launch, we can expect to see heightened volatility in the 2019 and 2022 bond prices. The performance of these bonds will be directly linked to the future path of iron ore prices. We outline our views on the 2019 and 2022 bonds as follows:

• If you believe iron ore prices will continue to rise and the iron ore market will rebound from a recent price low around USD47 per tonne, then the senior unsecured bonds continue to represent good value. We continue to prefer the 2019s over the 2022s. With USD6bn of debt to be repaid in 2019, the prospect of an early call on the 2019 bonds remains highly likely. On the other hand, the 2022s remain the last ranking debt tranche on Fortescue’s balance sheet, and with significantly more secured debt in the mix their risk profile has increased
• If your view is that iron ore prices have further to fall over the medium term, for example to USD40 per tonne and below, then it may be an opportunity in the short term to take advantage of this recent rally on Fortescue’s bond prices and de-risk from a position before a further fall in bond prices

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